Sequencing Risk – The deadly trap for the unsuspecting

In my view, the potentially devastating consequences of Sequencing Risk is one of the most poorly understood issues in Australia.

The next time a client tells you they have their affairs “under control” and don’t need financial advice, ask them if they understand Sequencing Risk and how it can devastate the most well structured plan if it is ignored.

We often hear investment spoken about in terms of ‘average’ returns. That is, day-to-day fluctuations in value is said to be a non-issue if you are a long term investor, as all you need to do is focus on what the ‘average’ return will be over time.

Sound like a familiar argument?

Well, it’s true that end results can be equal over time if the market average is equal over the period but what this advice ignores is something very deadly and potentially highly lethal. It’s called ‘sequencing risk’ and refers to the timing of your entry and/or exit from the market. Get this wrong and you can be in a world of pain.

So what is Sequencing Risk?

Sequencing Risk is typically greatest at the point of retirement, when you switch from building up your nest egg to drawing an income from it. This is because there is usually more money at risk if markets drop around the time of retirement.

Unexpected investment losses close to or during the early stages of retirement could lead to undesired consequences such as delaying retirement and working for longer, discarding holiday plans and/or reducing your expenditure. During retirement, each time you make a withdrawal, you are reducing the balance of your savings, and as the balance falls, the timing of when losses happen will have a greater impact on your future wealth. As you will see from the example below, sequencing risk has the potential to make a larger difference to how long your savings will last in retirement, and should be addressed well before you reach retirement as part of a transition strategy.

Example:

Investor A and investor B both start retirement with an opening balance of $691,527. Both withdraw an annual income of 5% of the opening balance (approximately $35,000), adjusted for inflation of 3% per annum.

Again, both portfolios generate the same investment returns – however, the pattern of these returns is reversed. So, investor A’s portfolio will deliver three consecutive negative returns early on in the period, while investor B’s portfolio will deliver negative returns at the end of the period.

In this example, the pattern of returns has made a big difference. Regular withdrawals, together with a string of poor investment returns early on mean Investor A has less time to recover from the damaging market events. This is because the portfolio has less money to rebound in value. Unfortunately, even though they started off with exactly the same amount of funds, Investor A will have his funds depleted by age 80. Investor B will continue to accumulate wealth in retirement despite making the same annual withdrawals as Investor A. This is because Investor B has the better fortune of starting his retirement when the markets delivered three consecutive years of positive, double-digits returns.

Looked at another way we can see that a huge opportunity can be missed by investors if they simply ignore sequencing risk. In the following example, Investor B could have been massively in front of Investor A if he’d taken action at age 62 and adjusted his asset allocation.

However, since he sat and did nothing, his assets lost nearly $500,000 on the way through greatly diminishing his lifestyle in retirement.

This is how simply looking at average earnings over time and hoping for the best can be so very damaging. In other words, fail to plan and you plan to fail.

The No1 Rule – Whatever your age – get professional financial advice right away.

Written by:
David Haycock, Omnia Group

Important Note: Omnia and David Heycock are licensed to sell real estate and are not licensed providers of credit, financial planning advice, tax advice or investment planning advice and do not hold themselves up to be a specialists in any of these areas. Any comments made above are of a general nature only and should not be used as any form of specific advice that might influence your decision to act in any way. Any such decisions should only be made with advice from a licensed credit provider or appropriately licensed financial adviser or tax accountant.